How to ward off the next recession

By Jean Pisani-Ferry

Structural shifts in the automobile industry, miserable productivity gains in advanced economies, shrinking spare capacity, and the build-up of financial fragilities would be sufficient causes for concern, even in normal times. But there is more: a combination of cracks in the global trading system and an unprecedented shortage of policy ammunition are adding to the worries.

As the OECD emphasised, a good part of the slowdown can be attributed to the ongoing Sino-American trade dispute. Chad Bown of the Peterson Institute reckons that the average US tariff on imports from China will increase from 3% two years ago to 27% by the end of this year, while Chinese tariffs on US goods will rise from 8% to 25% over the same period. These are sharp enough increases to disrupt supply chains. Anxieties over a further escalation inevitably dent investment.

Moreover, President Trump’s erratic tariff policy is symptomatic of a broader reassessment of global production networks. Even if Trump is not re-elected in 2020, there are hardly any free traders left in America. The damage to the global trade regime from rising nationalism is likely to outlast him. Climate-related grievances against the unfettered search for lower production costs are bound to grow further.

The other big concern is the lack of policy tools to counter a slowdown. In a normal recession, central banks cut interest rates aggressively to prop up demand. The US Federal Reserve, for example, lowered rates by five percentage points in each of the last three recessions.

Today, however, the Fed only has about half its normal room to cut rates, while the European Central Bank (ECB) has very little. Risk-free rates in the eurozone are already negative, even on 30-year bonds. And after the ECB recently loosened policy under outgoing President Mario Draghi, his successor Christine Lagarde will inherit a sparse toolbox.

As Lagarde has said, “central banks are not the only game in town.” Both she and Draghi have called on eurozone governments to provide more fiscal stimulus. On paper, this looks feasible: whereas the US cyclically-adjusted budget deficit exceeds 6% of GDP, the average deficit in the eurozone remains below 1%. And the debt-to-GDP ratio in the eurozone, though high, is lower than in the US. Furthermore, as former International Monetary Fund chief economist Olivier Blanchard has emphasised, temporary deficits do not imply a lasting increase in the debt-to-GDP ratio when the interest rate is well below the growth rate, as it is now.

European finance ministers, however, did not even consider contingent fiscal plans at their most recent meeting in September. And Germany, which has room to act, still opposes relaxing its “black zero” requirement, according to which parliament must approve a balanced budget (and deficits are permissible only if growth undershoots expectations). While calls to lift this self-imposed constraint are growing louder, the separate “debt brake” enshrined in Germany’s constitution limits the cyclically adjusted federal deficit to 0.35% of GDP.

Eurozone governments thus have only limited room for fiscal manoeuvre and may lack the political courage to enlarge it. Most likely, therefore, Europe will muddle through with some recession-induced fiscal easing but no aggressive response.

And yet, a decade after the Great Recession, Europe’s economy is still convalescing, and another period of prolonged hardship would cause severe economic and political damage. Policymakers should, therefore, explore alternative options.

That brings us to the outlandish idea of equipping the ECB with new tools. In the late 1960s, Milton Friedman, the father of monetarism, imagined that a central bank could drop banknotes by helicopter – a metaphor that former Fed Chairman Ben Bernanke later used to explain how it could always do more to counter deflation.

To turn this thought experiment into a real policy option, the Eurosystem could extend perpetual, interest-free loans to banks in member countries, on the condition that they pass the money on to consumers under the same terms. Households would receive a €1,000 ($1,094) credit that they would never pay back – in effect, a transfer that would finance more consumption. Each member country’s central bank would either keep a fictional asset on its balance sheet or, more realistically, recoup the corresponding losses over time by reducing the annual dividend paid to its public shareholder.

Such an initiative would face considerable obstacles, however. The first is legal: would the ECB be acting within its mandate? Arguably, it would, provided such an operation were used to help achieve the ECB’s price stability objective. Eurozone inflation is currently too low, and a recession would aggravate this. The second problem is operational: some eurozone households have no bank account, while others have several; and should the same amount be extended households in Luxembourg and in Latvia, where income per head is four times lower? This may not matter from a macroeconomic standpoint, but it does in terms of equity. The final hurdle is political: the ECB would be accused of breaching the Chinese wall separating monetary and fiscal policy because the operation would be equivalent to a state-administered transfer financed by money creation. Given the current acrimony over its monetary strategy, that might be one controversy too far.

Time will tell if a deteriorating economic situation and the lack of alternative options justify entering unexplored territories. It is unlikely that Europe will have the guts for it. If it does, the path ahead will be perilously narrow and littered with obstacles. But ultimately, acting might be safer than kicking the can down the road.

Jean Pisani-Ferry holds the Tommaso Padoa Schioppa chair of the European University Institute in Florence and is a Senior Fellow at Bruegel, the European think tank. He is also a professor of economics with Sciences Po (Paris) and the Hertie School of Governance (Berlin).